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The Fed's radioactive housing hoard

By Colin Barr, senior writerApril 7, 2010: 11:35 AM ET

(Fortune) -- Central bankers are apt to say just about anything when it comes to defending the Federal Reserve's support for housing.

In a speech Tuesday, Minneapolis Fed President Narayana Kocherlakota sketched out a path the Fed could take to head off the inflationary threats posed by its massive bond purchases. As you might expect, Kocherlakota stressed that he believes rising inflation is "unlikely."

A Fed official claimed Tuesday that policymakers like Ben Bernanke have little influence on house prices.

But Kocherlakota, who joined the Minneapolis Fed last fall from the University of Minnesota, also made some surprising comments to the Minneapolis Chamber of Commerce.

First, he emphasized the Fed's purchases of mortgage-related debt aren't "toxic" -- at least not for the Fed.

Over the past year, the Fed has purchased more than $1 trillion of debt tied to Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), the troubled federally backed mortgage companies. Though bailout-soaked taxpayers may fret over the rising default rates on mortgages owned and guaranteed by the companies, Kocherlakota emphasized that the Fed is insulated from those concerns.

"Of course, if many borrowers do default on their mortgages, taxpayers suffer losses because taxpayers are backing Fannie Mae and Freddie Mac," he said. "But those losses are an issue for Congress and the Treasury -- they do not find their way through to the Federal Reserve."

Consider yourself reassured. That said, even if the bonds aren't poisonous for central bankers, Kocherlakota suggested the Fed might do well to start selling them once the recovery is firmly in place.

That's because the Fed generally isn't comfortable holding long-term bonds, which lose value when interest rates rise. Rates have risen over the past month and are widely expected to go higher in coming years.

Expanding on comments made last month by Fed chief Ben Bernanke, Kocherlakota laid out a plan that could speed the Fed's exit from the mortgage markets. He said the Fed could, for instance, sell between $15 billion and $25 billion worth of the mortgage bonds each month -- without upsetting the market and causing interest rates to spike.

Over time, the sales would slim the Fed's balance sheet and eat into the idle reserve balances at banks. Those balances, which are normally run to just a few billion dollars, currently amount to $1.13 trillion. That's cash banks could lend out in an economic upswing, potentially fueling inflation.

Sales may be necessary, Kocherlakota said, because otherwise the central bank could be left managing a bigger, riskier balance sheet for years.

"I am optimistic that we will be able to normalize our balance sheet by the end of the teens," he said.

He said an internal analysis predicts that without sales, the Fed could still be carrying $250 billion of mortgages in 2030. The problem, the Minnesota Fed concluded, is that "only half of the mortgages will vanish from the balance sheet every 10 years."

That is, the Fed's bonds have a dangerously long half-life. It wouldn't be the first time the mortgage business turned radioactive.